I'm here to discuss risk taking. R-squared is for Ranting and Raving, R&R, as well as some more technical topics

Friday, August 13, 2010

Vacation in Catastrophe Land, Part I

I'm no expert on Iceland. Certainly not after only ten days. However, I plan on milking this vacation for several posts. Let's see how that goes.

In the tourist junk shop, I showed the pictured product to my daughter, the accounting expert. Her reaction? "Dad, they want ISK1500 for an empty can? That's a lot of goodwill." A very proud moment for me!

[I just noticed I never finished my post titled "Accounting for 10 Year Olds". The very short story: I taught my daughter about "goodwill" on company balance sheets. For those lucky enough to not know what goodwill is, let's just say it's the difference between what something costs you and what it might really be worth...and you get to call that difference an asset. As my daughter says, the used Barbi is worth $0.10, but if she gives you $99.90 of "goodwill" you may now justify paying her $100 for it.]

Take nothing. Package it. Now sell it for ISK1500. Maybe someone will buy it. Even if they don't buy it, let's pretend it's worth something. That seems to me Iceland's economy circa 2007.

In a nutshell, Iceland's financial crisis revolved around trying to make money selling nothing...a common practice in 2007. Bank depositors, especially British ones, thought they could earn high interest rates by leaving their money in Icelandic banks. No one asked how Icelandic banks could pay these rates. (Remember, for a bank to pay you crazy high interest rates, they have to earn more than that on their own investments!)

What happened? Depositors swamped Iceland's tiny economy, but no one cared. Depositors invested in canned air. They figured the banks would figure something out, or more likely they didn't care. The bankers had too much cash, so they too started buying canned air. Eventually, probably some 10 year old, said "hey, that's canned air. It's not worth anything!" And everything unraveled from there.

But, catastrophes are not new to Icelanders. They've faced them for 1000 years.

Interesting fact: Iceland doesn't have (many) trees. Most people think this reflects a natural state of affairs. Not true. The "sagas" tell tales of forests so impenetrable , all exploration of the new land began by moving upstream through glacial rivers. But then, the settlers burned all the trees for heat. More on this later...

3 comments:

I'm all for capitalism but it seems like a lot of financial crises come down to greed. In this case, the bankers wanted ever more depositors, and the depositors wanted unfairly high returns (better returns than their expected risk merited). Thoughts?

Specifically, I don't know what to do with your words "capitalism", "greed" and "unfairly high returns".

Capitalism is a Marxist term, having little to do with economics or finance. At best, it's a term that relates to property rights, but most do not understand it that way. Greed reflects an opinion about someone else's behavior. Finally, investment returns have little to do with fairness!

So, I'm not sure what thoughts of mine you'd like?

If I rephrase what you wrote as "I'm all in favor of private ownership of the means of production, but owners of property are greedy and cannot be trusted to act in the best interests of society because they might earn more than what others earn, so I am not sure I mean what I said in the first place" then I'd say I prefer property rights to the alternative.

The issue in Iceland seems to be that the banks promised, "Deposit your money with us and you'll get 8% above inflation, with no additional risk!" As an Icelandic depositor, I'd give them my money, because I'm greedy (in the sense that they're promising I'll get something for nothing, and who wouldn't want that?). But really, they were just claiming crazy interest rates to grab my deposits -- they didn't have a sustainable way to continue giving everyone that extra 6%. So the depositors were greedy (getting something for nothing) and the banks were greedy (also getting something for nothing).

My preface about "capitalism" is that I'm not attacking the financial system in the first place... just how it was executed in this particular situation. It seems like it would be easier to describe if it were an investing situation, rather than a depository situation.

I'm not sure that's any more clear, but thanks for considering my comments.

About Me

Since completing my PhD in economics at the University of Chicago, I have worked at financial firms ranging from the insanely large (JP Morgan) to the ridiculously small (my current venture has one employee!) with stops in between investing for McKinsey & Company, and Silver Creek Capital Management. I have served on company boards, both public and private.
You can reach me at marc@riskrsquared.com